Lower trend growth the reality says Smith & Williamson’s Philip Lawlor
Philip Lawlor, group strategist at Smith & Williamson says that now is not the time to be swayed by high-frequency newsflow and economic data.
These are fascinating times to be involved in determining investment policy. While we all have a tendency to be swayed by the profusion of high-frequency newsflow and economic data, we also have to make a conscious effort to step back and identify key strategic issues.
As I write, markets are responding to three simultaneous and historically significant strategic pivot points.
The first is the turmoil in the eurozone; the second is the transfer of wealth from the west to the east; the third the downshift in UK and US trend growth – has not received nearly as much media and analytical attention as the first two, but is still very important.
Trend growth is a key concept constantly referred to by economists, politicians and central banks.
There is a tendency to treat trend growth as a constant data point. This notion is dangerous.
In an analysis of what went wrong in Japan in the 1990s, a US Federal Reserve Bank study (Discussion Paper 729 2002) identified one of the key mistakes made by forecasters at the time was their inability to identify a shift in Japan’s medium-run prospects trend growth.
Most observers assumed Japan would return to the high growth rates of the prior decade. This assumption spawned a sequence of inappropriate policy responses that ultimately pushed Japan towards the lost decade and deflation.
Problems… in theory
The problem with trend growth is it is a theoretical construct and not a data series that appears on our monitors.
It is a function of two components: labour force growth and productivity growth. Having worked off a model of 3% trend growth (1% labour force growth and 2% productivity growth) for the last 20 years, latest demographic profiling, together with the assumption of a modest downshift in productivity growth, has seen the CBO (US) and the OBR (UK) reduce their trend growth estimates to 2.3% and 2.1% respectively over the next 10 years.
Actual GDP growth in the UK compounded at 3% between 1994 and 2008, matching the theoretical estimate.
The clear risk is, as we saw in Japan in the 1990s, mean reversion assumptions remain anchored to the old growth rates for too long and are too slow to recalibrate to the new trajectory.
For instance, examining the economic estimates used in the UK Budget in March, it can be observed it assumes the UK will return to about 3% growth (the familiar trend growth rate) between 2013-15.
Sadly, given UK GDP is three years from (and 4% below) the prior peak level and is clearly struggling with the dual headwinds of deleveraging and austerity, these forecasts resemble hope over expectation.
I suspect the gravitational pull on the OBR to start factoring in their own lower trend growth estimates into subsequent Budget forecasts is building.